Did Spain Commit Economic Suicide?

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A casual observer of the world's financial markets would have been forgiven two weeks ago for assuming that Spain's fiscal situation no longer threatened the integrity of the euro. The Iberian country's cyclically adjusted debt-to-GDP ratio is an extremely manageable 66%, and as recently as March 20, its government had auctioned one-year treasury bills at just over 1.4% in annual interest, the lowest yield in nearly two years.

However, it's now clear that any such relief was premature. On March 22, Spain's 10-year bond yield jumped to 5.5%, the highest rate in three months. The concern? A growing number of economists and analysts are warning that the Spanish economy -- the continent's fourth largest after those of Germany, France, and Italy -- is in much worse shape than once thought.

It's all about the deficitThe main problem can be summed up in two words: fiscal deficit. As a party to the Maastricht Treaty, the agreement that lays out the criteria for membership in the euro's monetary union, Spain is prohibited from running an annual fiscal deficit that exceeds 3% of its GDP. While this wasn't an issue from 2000 to 2008, during which the country regularly recorded fiscal surpluses, it has since become one. For much of the intervening time period, Spain's quarterly deficit has been anywhere in a range from 8% to 11.5% of the country's GDP. In the most recent quarter on record, it was just short of 9%.

Sources: Eurostat and author's own calculations.

Sources: Eurostat and author's own calculations.

The country has adopted a three-pronged approach to comply with its treaty obligations by the end of 2013. The first prong includes tax increases to increase the central government's revenue. All told, the increase is estimated to be in the range of 12.3 billion euros, with 2.5 billion euros coming from a temporary amnesty on unpaid taxes in the black market, and 5.3 billion euros coming from corporate-tax adjustments, such as the elimination of a goodwill tax break that made it easier for Spanish companies to buy foreign rivals and boosted overseas expansions by the likes of Telefonica (NYS: TEF) and Banco Santander (NYS: STD) , among others.

The second prong includes a 13.4 billion euro reduction, or 17%,in the central government's budget. The ministries of industry and agriculture, for instance, will lose approximately 30% each, and the ministry of foreign affairs and cooperation will lose 54% of its funding. In addition, the government said it will slash energy subsidies and increase electricity bills for consumers by 7%, as the government looks to tackle a 24 billion-euro so-called electricity tariff deficit used by recent governments to encourage the adoption of clean energies.

The final prong includes a number of structural adjustments to the country's notoriously rigid labor market designed to encourage business and reduce the country's record 23% unemployment rate. To name a few, the maximum severance payment possible will fall from 42 months to 24 months; struggling companies will be allowed to reduce employees' working hours; and in a policy focused on endemic youth unemployment, which stands at 50% in some regions, companies that have fewer than 50 employees will receive a 3,000 euro tax break for hiring workers that are under 30 and seeking their first job.

The promise and perils of austerityTo say that these measures are controversial both domestically and internationally would be an egregious understatement. On the day before the austerity package was revealed, as is becoming all too common in cities across Europe, Spanish workers took to the streets in protest. Factory workers, teachers, and public-transport employees joined the strike in large numbers. More than half of scheduled passenger flights were cancelled by mid-morning last Thursday. And demand for electricity fell by up to a quarter from normal levels. According to the interior ministry, 58 people had been arrested and nine injured.

The measures also place Spain at the center of an increasingly visceral debate among economists about the prescience and utility of austerity during economic contractions. Classical economists, among them Harvard professor Alberto Alesina, believe that measures like those enacted by the Spanish government not only decrease a country's debt-to-GDP ratio but actually trigger economic growth. Sometimes -- even often, according to Alesina -- economies prosper nicely after a government's deficit is sharply reduced because the program boosts confidence in such a way as to ignite a recovery.

Alternatively, Keynesians like Princeton professor and New York Times columnist Paul Krugman and former Treasury Secretary Lawrence Summers argue that such measures are counterproductive. To summarize their position, which I more or less ascribe to, they believe that spending cuts and tax increases will only force Spain deeper into recession and thereby exacerbate the country's already intolerably high level of unemployment. The answer to Spain's problems, according to Krugman and Summers, is more spending, not less.

And on a final and more fundamental level, the simple fact that Spain feels obliged to enact such extreme measures in response to pressure from the European Union calls into question the very structure of the continent's monetary bloc. In this regard, it's important to note that Spain's public debt-to-GDP ratio of 66% places its government in a markedly better fiscal position than the majority of its European peers. The rest of the so-called PIIGS -- Portugal, Italy, Ireland, and Greece -- all have public debt-to-GDP ratios near or exceeding 100%. Even Germany, the ostensible pillar of fiscal and economic conservatism, has a ratio of 83%. Thus, to subject Spain to similar measures as those forced upon Greece or Ireland seems both inequitable and unwise.

Cutting off your nose to spite your faceMake no mistake about it. Spain's unemployment situation and fiscal deficit are serious problems. Yet for the European Union to potentially compound these issues by hoisting draconian austerity measures upon it seems counterproductive to say the least. And if this experiment goes poorly, it isn't much of a leap to see how companies in other European countries, such as Greek shipper DryShips (NAS: DRYS) and Ireland's Bank of Ireland (NYS: IRE) , could go down with it. European operations like these are already listing heavily, and Spain's descent into depression could send them over the edge if it threatens the integrity of the euro.

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At the time this article was published Fool contributor John Maxfield has no financial position in any of the companies mentioned above. The Motley Fool owns shares of The Bank of Ireland. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.